Exchange-traded funds (ETFs) are a very popular investment choice. There were 2,391 of them available on the market with almost $5.49 trillion of assets under management as of December 31, 2020. ETFs can be used as building blocks for virtually any type investment strategy, from the most basic to highly sophisticated hedging.
Learn about the different ETF strategies and how you can use them in your portfolio.
- ETFs are a cost-effective way to invest in many securities at once while still having the liquidity of owning individual stocks.
- Index ETFs follow a large stock index like the S&P 500, while multi-asset ETFs hold different stocks, bonds, and real estate in a single fund.
- You can choose ETFs based on how much risk you want to take on, including leveraged ETFs, international ETFs, or risk management ETFs.
- Some ETFs focus on specific sectors or hold only socially responsible securities, which let you create a portfolio that aligns with your values.
Why ETFs Are Good For Your Portfolio
ETFs are an affordable way for anyone to invest and get the benefits of diversification and professional money management. As baskets of securities that are traded on exchanges like the Nasdaq and the New York Stock Exchange (NYSE), they are a cost-effective way to invest in many different stocks, bonds, or other assets. ETFs are liquid, just like individual stocks. They typically have very low expenses and minimum purchase levels. ETFs are also transparent, publishing their holdings daily.
Investors who are just getting started can use ETFs to pursue a basic investment strategy with very little money.
Diversifying Your Portfolio
Investors diversify their portfolios into different asset classes (e.g., stocks, bonds, or real estate) to get the most return for the risk that they are willing to take. A basic diversification strategy includes holding domestic stocks, international stocks, and bonds. Conservative investors will have more bonds in their portfolios, and aggressive investors will have more stocks, with a higher percentage that are international. If you are just getting started in investing, a multi-asset ETF could be a good place to begin.
A multi-asset ETF includes different types of assets, such as stocks, bonds, real estate, or cash within a single fund. The fund managers decide what and how much to invest in to achieve the investment objective. For example, an aggressive multi-asset ETF with an objective of capital appreciation might include emerging markets and small-capitalization stocks. On the other hand, a conservative multi-asset ETF with an objective of earning income might include investment-grade bonds, and blue-chip stocks.
Basic Index ETFs
More experienced investors can build their own diversified portfolios by using indexed ETFs. These ETFs hold investments that match the returns of a financial index, like the S&P 500 or the Bloomberg Barclays U.S. bond index.
Index ETFs are a simple way to invest in broad segments of the stock, bond, real estate, and commodities markets.
Style and Factor ETFs
Within asset classes, there are investment styles that will often perform differently, depending on the economic conditions. Stocks are typically classed by capitalization size: small, medium, or large, and as value or growth investments. Fixed-income styles are classed by interest rate sensitivity and credit rating.
ETFs are available for any investment style. For example, you can invest in ETFs that track the CRSP (Center for Research in Securities Prices) small-cap value stock index. Another choice could be an ETF that tracks the Barclays Capital U.S. High Yield Corporate Bond Index, which will invest only in high yield bonds. Factor ETFs focus on companies that have specific financial or trading characteristics, like strong balance sheets or an upward price trend.
Investors use sector and industry ETFs to align their holdings with the stages of the business cycle. Utilities and consumer staples, for instance, perform well during recessions, while the consumer discretionary sector does well during expansions. Each sector of the economy, and some industries within those sectors, are tracked by an index, and there are ETFs available for every sector.
Economic and political conditions can favor some areas of the world more than others. Investors can use international ETFs to capitalize on growth opportunities in different countries and regions. The largest international ETF tracks the FTSE index of developed countries, excluding the U.S.
Socially Responsible ETFs
Socially responsible investing evaluates companies based on how well they support environmental, social, and governance (ESG) issues. The firm MSCI rates 14,000 companies for social responsibility and publishes indexes that track different characteristics. There are around 134 socially responsible ETFs available on the U.S. markets.
Risk Management ETFs
Investors can use ETFs to hedge their portfolios against markets that are moving downward. Inverse ETFs show gains when an index is down, and losses when it is moving up. Common inverse ETFs track the S&P 500. Long/short ETFs in this category buy and short-sell underlying investments based on share-price characteristics.
Long/short funds try to maximize the upside potential of a market by purchasing shares that are undervalued. They attempt to limit risk by short-selling shares that are overvalued.
Leveraged ETFs are only appropriate for experienced, sophisticated investors who understand the risks. Leveraged ETFs are designed to deliver a multiple of an index return on a daily basis. For example, a 2x S&P 500 ETF is designed to double the S&P 500 return daily. Leveraged ETFs use debt, options, short selling, and other methods to achieve their objectives. Leveraged ETFs magnify both gains and losses.
The Bottom Line
ETFs let new investors take advantage of professional money management. Seasoned investors can use them to capitalize on specific areas of opportunity based on conditions. ETFs can also be used for highly sophisticated leveraged and short-selling strategies.
Remember that ETFs:
- Are liquid, cost-effective, and transparent
- Can be used as building blocks for any investment strategy
- Can be used to diversify and take advantage of investment opportunities in virtually any market, region, or sector
Do your research before you invest, and consider how much risk you are comfortable with. If you are new to investing, consider getting assistance from a professional financial advisor.
The Balance does not provide tax, investment, or financial services or advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.